The Challenge Facing ESG Investors

The data used to construct environmental, social and governance (ESG) portfolios differs widely among providers, meaning that funds may not be aligned with your clients’ objectives and beliefs.

The trend toward investors incorporating ESG strategies into portfolios has been growing at a rapid pace. Morningstar reported that in 2019 estimated net inflows into ESG funds totaled more than $20 billion, a nearly fourfold increase from the prior year. According to the Global Sustainable Investment Alliance, ESG investing now accounts for more than $12 trillion – one out of every four dollars under professional management in the United States and one out of every two dollars in Europe.

One problem facing those who desire to incorporate ESG strategies is that the category is far from homogeneous, with the same stock often having very different ratings from the various providers of ESG scores. Jan-Carl Plagge and Douglas Grim, of the research team at Vanguard, highlighted this problem in their study, “Have Investors Paid a Performance Price? Examining the Behavior of ESG Equity Funds,” which appeared in the February 2020 issue of The Journal of Portfolio Management. Among their findings was that the return and risk of ESG funds can differ significantly and are driven by fund-specific criteria rather than by a homogeneous ESG factor. This finding led them to conclude that due to the wide dispersion of outcomes caused by systematic differences in portfolio holdings, investors are best served by assessing investment implications on a fund-by-fund basis. They added: “Our mixed and dispersed performance results suggest that it is difficult to make generalizations on the investment risk and return impact when replacing a conventional U.S. equity fund with an ESG fund. Carefully assessing the important and unique attributes of both funds seems to be an essential step in determining the potential direction and magnitude of any differences.”

The Research Affiliates study, “What a Difference an ESG Ratings Provider Makes!” examined the issue of the highly heterogeneous state of ESG investing. To provide investors with a better understanding of the ESG landscape, the authors, Feifei Li and Ari Polychronopoulos, reviewed ESG data providers. They then constructed ESG portfolios using different providers’ data to illustrate how the providers are incorporating their subjective judgments into the ratings, which leads to very different portfolio outcomes. Highlighting the problem, that they identified 70 different firms that provide ESG ratings data. And this didn’t even include the multitude of investment banks, government organizations and research organizations that conduct ESG-related research that can be used to create customized ratings.